Productivity Puzzle Persists in U.K.

British firms’ labor costs are rising at a faster clip than their competitors elsewhere in the developed world, a reflection of a puzzling productivity slump in the U.K. that could pose problems for the economy.

The Organization for Economic Cooperation and Development, a Paris-based think tank, said in a report this month that unit labor costs in the U.K. rose 2.4% in the second quarter compared with the first, outpacing the rate of growth in Germany, France, Italy and the U.S. The average rise in unit labor costs in the OECD’s 34 members was just 0.3%, the organization said.

A rise in unit labor costs means wage growth is outpacing productivity gains. If this rapid growth persists, that could put U.K. firms at a disadvantage to foreign rivals when competing for business, scotching policy makers’ ambitions to rebalance the economy towards exports. It may also heap pressure on companies to raise prices, potentially stoking inflation and complicating the Bank of England’s task of steering the economy back to health.

The U.K. has experienced a sharp slump in productivity in recent years that economists are struggling to fully explain. Output has been broadly flat for two years but employment has remained surprisingly buoyant given the depth of the recession that followed the near-collapse of the global financial system in 2008.

The result: output per worker in the U.K. was 20 percentage points lower in 2011 than the average in the Group of Seven industrialized nations. Total pay, excluding bonuses, rose 1% in 2011, putting pressure on firms’ labor costs even as productivity slumped, a trend that has continued.

“It’s a bit unsurprising unit labor costs are higher than they were two years ago,” said Jim Bligh, head of labor market policy at the Confederation of British Industry, a business group.

Mr. Bligh said British businesses have avoided laying off skilled staff where they can, opting instead to negotiate shorter hours or lower pay with workers. That’s meant their wage bills have been a little higher than they could have been given the weakness of output.

Mr. Bligh said if weak productivity were to persist then that would be “a significant worry” for U.K. businesses trying to compete with traditional rivals like Germany and newer ones like Singapore.

But he added one possible explanation for the puzzling disparity between employment and output data is simply that the economy is actually healthier than the output estimates suggest, and normal revisions to the official figures will eventually show much of the weakness in productivity, and hence the strength of unit labor costs, was illusory.

“The output data does appear to be contrary to what we are picking up in our business surveys,” Mr. Bligh said.

The question of what’s causing the weakness in productivity is also exercising the minds of officials at the Bank of England, where productivity is at the heart of an increasingly vocal debate among policy makers over the wisdom of more stimulus for the U.K. economy.

The BOE has kept its key interest rate at a record low of 0.5% since March 2009 and in July raised the target for its bond-buying stimulus program to 375 billion pounds ($607 billion).

The central bank is tipped to raise its bond-buying target again in November to foster recovery in an economy that economists think may shrink by 0.3% this year, according to forecasts compiled by the treasury.

But some rate-setters appear nervous. Spencer Dale, the central bank’s chief economist, said weak productivity could suggest the economy’s capacity to produce goods and services has taken a hit from the financial crisis. If that’s true, then there are risks to adding more stimulus.

“Stimulating in an environment where the supply side of the economy is damaged is likely to quickly run up against capacity constraints and cause inflationary pressures,” said Philip Rush, an economist at Nomura. Annual inflation in the U.K. was 2.5% in August, and the BOE warned in the minutes of its September policy meeting that rising unit labor costs risked delaying inflation’s anticipated retreat to its 2% target.

For others on the BOE’s rate-setting panel, notably David Miles, a supporter of more expansionary monetary policy, the weakness in productivity is primarily a reflection of a weakness in demand and a degree of spare capacity both within firms and in the economy as a whole. Stimulate demand with more bond-buying, they say, and these idle resources will be used up, boosting productivity and raising output without causing a surge in inflation.

Felicity Burch, an economist at EEF, which represents manufacturers, said there’s some evidence this is happening in the manufacturing sector. Some firms saw a rise in productivity earlier this year as demand for their goods picks up, particularly from fast-growing emerging markets, she said.

“There’s still quite a lot of spare capacity out there,” said Andrew Goodwin, senior economic adviser to the Ernst & Young Item Club, a forecasting group, who thinks the BOE has plenty of room to loosen monetary policy further.

BOE officials who appear particularly concerned about the economy’s supply side, like Mr. Dale and his colleague Ben Broadbent, have honed in on Britain’s financial sector as a possible cause of the capacity constraints they worry about. Mr. Broadbent said Britain’s weakened banks may mean it’s hard for the economy to shift capital from unproductive sectors to highly-productive enterprises, stymieing growth and weakening productivity.

The central bank’s efforts to revive the economy now include trying to fix this logjam. The BOE has launched a funding for lending scheme that offers lenders cheap central bank money provided they use it to make new loans. Thirteen banks have signed up so far, and according to a BOE survey published Wednesday the most immediate beneficiary looks likely to be the housing market, as banks say they plan to increase the number of home loans available significantly in the fourth quarter of the year.

Lending to businesses is expected to remain more subdued, the survey found,. However, BOE officials say they’re confident the scheme will ultimately help the supply of credit to the whole economy, potentially alleviating at least one strain that may help explain the U.K.’s productivity puzzle.

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